How the Policy of Price Stability Generates Greater Economic Instability

Many mainstream economists believe that economic stability refers to an absence of excessive fluctuations in the overall economy…

by Frank Shostak via Mises

Many mainstream economists believe that economic stability refers to an absence of excessive fluctuations in the overall economy. An economy with constant output growth and low and stable price inflation is likely to be regarded as stable, while an economy with frequent boom-bust cycles and variable price inflation would be seen as unstable.

According to popular thinking a stable economic environment with stable price inflation and stable output growth acts as a buffer against shocks, making it easier for businesses to plan. Thus, price level stability is the key for so-called economic stability.

Assume that people increase demand for potatoes versus tomatoes. This relative strengthening is depicted by the relative increase in the prices of potatoes. Successful businesses must pay attention to consumers’ instructions demonstrated by changes in the relative prices of goods and services, while failing to abide by consumers’ wishes will result to the wrong production mix of goods and services and will lead to losses. Hence, in our example, when businesses attention to relative changes in prices they will make correct decisions.

If the price level is not stable, then the visibility of the relative price changes becomes blurred and, consequently, businesses cannot ascertain the relative changes in the demand for goods and services and make correct production decisions, according to the economic mainstream. This supposedly leads to misallocation of resources and the weakening of economic fundamentals. Hence, unstable changes in the price level obscure changes in the relative prices of goods and services. Consequently, businesses supposedly will find it difficult to recognize changes in relative prices when the price level is unstable.

This way of thinking justifies the mandate of the central bank to pursue policies that will bring price stability—i.e., a stable price level, with price level stability measured by popular price indexes such as the Consumer Price Index (CPI). By means of various quantitative methods, the Fed’s economists have established the present policy of keeping price inflation at 2 percent. Any significant deviation from this figure constitutes deviation from the growth path of price stability.

Observe that Fed policy makers are telling us that they must stabilize the price level in order to allow the efficient functioning of the market economy. Obviously, this is a contradiction in terms, since any attempt to manipulate the so-called price level implies interference with markets and hence leads to false signals as conveyed by changes in relative prices.

Policy of Price Stability Leads to More Instability

Assume the rate of the so-called price level visibly declines, so to prevent this decline the Fed aggressively pushes money into the banking system. Because of this policy the price level stabilizes over time.

Should we regard this as a successful monetary policy action? The answer is categorically no. Given that monetary pumping sets in motion the diversion of wealth from wealth generating activities to non-wealth-generating activities, this policy weakens the wealth generation process and leads to an economic impoverishment.

Note that the economic impoverishment has taken place despite price level stability. Note also that in order to achieve price stability, the Fed engineered an increase in the growth rate of money supply.

The fluctuations in the growth rate of money supply matter. This sets in motion the menace of the boom-bust cycle regardless of stability of the price level.

While increases in money supply are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors. Consequently, if real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might occur.

While money growth is buoyant, prices might display moderate increases. Clearly, if we were to pay attention to the so-called price level and disregard increases in the money supply, we would reach misleading conclusions regarding the state of the economy.

Price Level Cannot Be Ascertained Conceptually

The whole idea of the general purchasing power of money and hence the price level cannot, be even established conceptually. When one dollar is exchanged for one loaf of bread, we can say that the purchasing power of one dollar is one loaf of bread. If one dollar is exchanged for two tomatoes, then this also means that the purchasing power of one dollar is two tomatoes.

The information regarding the specific purchasing power of money does not, however, permit the establishment of the total purchasing power of money. It is not possible to ascertain the total purchasing power of money because we cannot add up two tomatoes and one loaf of bread.

We can only establish the purchasing power of money with respect to a particular good in a transaction at a given point in time and at a given place. On this Murray N. Rothbard wrote:

Since the general exchange-value, or PPM (purchasing power of money), of money cannot be quantitatively defined and isolated in any historical situation, and its changes cannot be defined or measured, it is obvious that it cannot be kept stable. If we do not know what something is, we cannot very well act to keep it constant.

Now, the Fed’s monetary policy that aims at stabilizing the price level by implication affects the growth rate of money supply. Since a central bank policy amounts to the tampering with relative prices, which leads to the disruption of the efficient allocation of resources. As a result, a policy of stabilizing prices leads to overproduction of some goods and underproduction of other goods. This, however, is not what the stabilizers are telling us. Instead, they hold that the greatest merit of stabilizing changes in the price level is that it allows free and transparent fluctuations in the relative prices, which in turn leads to the efficient allocation of scarce resources.

Economic Stability Has Nothing to Do with Stabilizing the Economy

We hold that economic stability is not about keeping prices stable but rather keeping price fluctuations free. Only in an environment free of government and central bank tampering with the economy free fluctuations in relative prices can take place.

This, in turn, allows businesses to abide by the instructions of consumers, which brings about an efficient allocation of scarce resources. We suggest that fluctuations in prices will mirror changes in the relative supply-demand conditions.

Summary and Conclusion

Most economists believe price stability is the key to healthy economic fundamentals. A stable price level, it is held, leads to the efficient use of the economy’s scarce resources and, hence, results in better economic fundamentals. It is not surprising that the mandate of the Federal Reserve is to pursue policies that will generate price stability.

By trying to stabilize the price level, the Fed undermines economic fundamentals. An ever-growing interference of the government and the central bank with the working of markets moves the US economy toward persistent economic impoverishment resulting in lower living standards.


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Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

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